In a note called ‘Crunch Time’, Goldman’s Jan Haztius lays out the case for QE to be announced at the next meeting:
Our confidence that the FOMC will ease policy once more at the June 19-20 meeting has also grown. At a time when Fed officials are far short of their dual mandate of maximum employment and 2% inflation, financial conditions should be accommodative and GDP growth should be well above trend in order to re-employ displaced workers and avoid a gradual transformation of cyclical into structural unemployment. Instead, financial conditions are only roughly at average levels according to our GSFCI, and GDP growth is below its long-term trend. Moreover, both financial conditions and growth have been moving in the wrong direction, to a degree that we think warrants action.
Assuming they do ease, what are Fed officials likely to do? It is a tricky call because there are many different options on the table. At the most basic level, they could increase the size of their balance sheet, change the composition of their balance sheet, and/or change their forward guidance in a way that pushes rate hike expectations even further into the future. If the easing comes via changes in the size or composition of the balance sheet, they could buy long-term Treasuries, mortgages, or both. If they decide to extend their balance sheet, they could add excess bank reserves or “sterilize” the reserve impact via reverse repos and/or term deposits. They would also need to decide whether to announce a balance sheet extension problem in one go or adopt a meeting-by-meeting strategy. And if they change the guidance, they could simply push out the date for the first rate hike in the statement or make the first hike conditional on an economic criterion such as a nominal GDP target or the Evans proposal (commit not to hike rates until the unemployment rate has fallen, or until inflation has risen, above a specific level).
Our baseline remains that Fed officials will purchase a mixture of mortgages and long-term Treasuries, financed via balance sheet expansion and possibly coupled with an extension of the forward guidance into 2015. This would be considerably more powerful than an extension of Operation Twist or other ways of changing the composition of the balance sheet, which are possible alternatives but are limited by the relatively modest amount ($200bn) of short-term paper that is still available for sale on the Fed’s balance sheet. We still think that Fed officials might decide to “sterilize” balance sheet expansion via reverse repurchases or term deposits. We may get a better sense on all of these issues from Chairman Bernanke’s testimony to the Joint Economic Committee of Congress on Thursday or other Fed speeches this week.